Let's look at the other side of the coin. Assume you are in the enviable position of being able to make a substantial down payment—more than the minimum the lender requires. Should you?

SUGGESTION: If your broker tells you that you'll need a "non-conforming" or "jumbo" loan, it means that the amount of the loan you need is higher than a pre-set national ceiling. The interest rate on these loans is higher than on normal mortgage loans. If making a larger down payment means bringing that loan balance down below the limit, you should consider doing so since interest rates on smaller conforming loans are less than on the jumbos, saving you money with every payment.

It could come down to your personal preference. Putting more money down means financing less. The lower your loan amount, the lower your monthly payment. You may feel more comfortable keeping your monthly payment low. Others may not be quite so focused on their monthly payment and may feel more comfortable keeping as much of their money as possible where they can get it in the event of an emergency. Paying a little more each month may be worth knowing you have readily accessible cash.

Now, let's look at it from a dollars and cents point of view. If you're going to be furnishing and decorating your new home by borrowing at high consumer credit rates, it makes sense for you to make a smaller down payment, borrow more at a lower mortgage rate (mortgage rates are typically lower than installment debt), and use the cash you didn't put down to cover your anticipated cash needs. Financially, you'll come out ahead.

SUGGESTION: If you have outstanding personal loans, it is to your advantage to finance as much of the price of the home as possible. By reserving as much of your cash as possible, you'll be able to pay off your personal debt. By doing so, you will convert non-deductible interest on the personal loan to potentially tax-deductible interest on the mortgage loan, and save some tax dollars.

Using Leverage

Your home is more than just where you live, it is also a significant investment. One way to boost your return on that investment is through leverage, the ability to make money while investing very little of your own cash. Rule of thumb: When inflation rates run the same as or higher than mortgage rates, borrow as much as you can. You'll be paying back your mortgage with dollars that are worth less than when you financed, boosting your rate of return.

Adopt this philosophy: If your money is growing at a higher after-tax rate than the after-tax rate at which a lender will loan you the money, borrow the money and leave those investments alone.

Let's look at an example. Michael has the following resources available to purchase his vacation home:

Sources of Funds

Amount Saved

Rate of Return

After-tax Return

Savings set aside for vacation home in a money market fund

$25,000

1%

0.8%

Stock mutual funds (non-retirement)

$35,000

6%

4.5%

Borrowing from 401(k) retirement assets

$50,000

6%

6%

Cash value life insurance

$10,000

3.5%

3.5%

Michael has spoken with several lenders and can secure a mortgage loan by putting 20% down, with a fixed interest rate of 4% and no points. He is in the 25% federal income tax bracket. What should he do?

First, Michael should calculate what the mortgage really costs him after taxes, assuming that his mortgage interest deduction would not be limited. This is calculated as follows:

Item

Amount

Tax bracket (1 − 0.25)

0.75

Multiplied by mortgage rate

x 0.04

After-tax cost of mortgage

3%

He would then compare the 3% net mortgage cost, or cost of funds, to the rate of return he is getting on his available resources. Investments earning more than 3% should be left alone, and not used to pay for the vacation home.

To summarize, he should use the savings he set aside for the vacation home, since it is only earning 0.8% after taxes. The rest of the money can be obtained from the 4% mortgage.

IMPORTANT NOTE: Your mortgage interest deduction may be limited if your Adjusted Gross Income exceeds certain limits. Contact your tax professional to determine if the interest will be tax-deductible.

IMPORTANT NOTE: The analysis of what you're paying versus what you're earning changes as economic and market conditions force changes in interest rates. If you make a small down payment and invest the difference, watch your situation. It could change in the future. If it does, you may want to take your invested money and pay down your mortgage.

One more thing. Before you sink all your available cash into your home, keep these often overlooked cash needs in mind:

You are going to need money for closing costs. We get into this a little bit further along, but the amount (excluding points) could be 2% to 4% of your loan amount.

Don't forget about other expenses. This includes moving expenses, buying new furniture, repairs and painting, buying window coverings, and decorating. This varies according to your specific situation, so budget for it carefully.

You need to retain an emergency fund. This should always enter into your financial planning considerations. Plan to have three months' worth of income or six months' worth of living expenses stashed away in a cash account.

Remember other personal goals you have identified. This includes the college fund for the kids or that new boat you've always wanted.